How To Think About Corporate Bonds

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martincmartin
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How To Think About Corporate Bonds

Post by martincmartin »

Experts
  • Jack Bogle seemed to think they're ok, e.g. recommending Vanguard's intermediate bond fund. Although he doesn't say why.
  • Bill Bernstein is against them: they go down during a recession, like stocks; there's an agency conflict where shareholders encourage companies to take risks, which is bad for bonds; they can be illiquid during a crisis.
  • Swedroe is against the broad range of investment-grade bonds, which are the only ones you can find in common low ER index funds, instead blessing only the highest quality ones. Says in the long run, they return about the same as Treasuries but are riskier, so you're not being compensated for the risk.
  • Swensen doesn't like them.
  • Rick Ferri likes them.
Theory
Corporate bonds are riskier than Treasuries because they carry default risk. They may also have a small negative convexity, but I think it's small enough to ignore.

The reason to hold them, in addition to Treasuries, would be diversification. But in what way do they diversify? For example, in what scenario do they move opposite to stocks or Treasuries?
  • In a recession, they go down, same as stocks.
  • When rates rise, they go down, just like all fixed rate bonds including Treasuries.
So their sweet spot is something like a deflationary expansion? Is that even a thing?

They seem to go up during good times, perhaps going up slightly more than Treasuries. But yield isn't the job of fixed income, that's for stocks. To be concrete, if I sold my corporates, then bought a little more stocks and bunch more Treasuries, wouldn't I have better yield with lower volatility, and less correlation with stocks?

Also, the weighting of bonds in an index isn't necessarily principled. Stock indices are typically weighted by market cap, which makes sense. Bond indices are weighted in proportion to how many bonds are out there, which means the most leveraged firms are weighted highest. It's not clear that's a good thing.

Data
nisiprius and others, is there a chart I should look at to help understand where corporates help with diversification, overall yield of my whole portfolio, or some other reason to hold them?
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nedsaid
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Re: How To Think About Corporate Bonds

Post by nedsaid »

I think that a diversified bond portfolio should include Treasuries, Government Agency Bonds, and Corporates. If you add Corporates to an otherwise
Treasury Bond portfolio, you will boost returns and volatility. If you keep everything Investment Grade, you will hardly know the difference whether you have Corporates or not, except that your returns will be higher. Corporates and TIPS can exhibit volatility in the shorter term but if you hang on, things usually resolve themselves within a few months, both were down 10-12% during the 2008-2009 financial crisis. What Mr. Bogle suggested was adding a good Corporate Bond Fund to the Total Bond Index Fund which is about 70% Treasuries and US Agency Bonds, he thought Total Bond had too much Governments.
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Re: How To Think About Corporate Bonds

Post by prioritarian »

nedsaid wrote: Thu Oct 28, 2021 4:37 pm If you add Corporates to an otherwise Treasury Bond portfolio, you will boost returns and volatility.
This may be true for shorter durations but longer duration treasuries have slightly better returns and risk-adjusted returns (and mixing the two does not result in higher returns than long Ts alone).

Blue: 60 US Market, 40 Total Bond
Red: 60 US Market, 40 Long Treasury Bond
Yellow: 60 US Market, 40 Long Corp Bond

Image

https://www.portfoliovisualizer.com/bac ... tion4_3=40
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Re: How To Think About Corporate Bonds

Post by nedsaid »

prioritarian wrote: Thu Oct 28, 2021 4:59 pm
nedsaid wrote: Thu Oct 28, 2021 4:37 pm If you add Corporates to an otherwise Treasury Bond portfolio, you will boost returns and volatility.
This may be true for shorter durations but longer duration treasuries have slightly better returns and risk-adjusted returns (and mixing the two does not result in higher returns than long Ts alone).

Blue: 60 US Market, 40 Total Bond
Red: 60 US Market, 40 Long Treasury Bond
Yellow: 60 US Market, 40 Long Corp Bond

Image

https://www.portfoliovisualizer.com/bac ... tion4_3=40
I am for Investment Grade and Intermediate Term. I have not invested in Long Term Bond Funds.
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000
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Re: How To Think About Corporate Bonds

Post by 000 »

People will bring out their charts and past data but we have to invest for the future.

What is the yield spread today? Does it seem big enough to you?

As yields get closer to zero, the duration risk of lower yielding treasuries becomes even higher than higher yielding corporates of same maturity because more of the total return comes later (STRIPS are the extreme case of this).

Treasuries aren't default free. There have been technical defaults before and there could be defaults in the future, such as a case where a unilateral adjustment of the terms of sovereign debt is more attractive to those making decisions than more printing.
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Re: How To Think About Corporate Bonds

Post by nisiprius »

During 2008-2009--looking only at intermediate-term bonds so the differences are strictly in credit quality--

Source

Image

While the stock market (not shown) was dropping -50%,
Junk bonds (blue) dropped -28%, about half as much as stocks
Corporate bonds (red) dropped -15%
Intermediate-term Treasuries (green) went up--but just a little, about 1%.

And Total Bond (yellow) went almost straight through. Apparently the losses in the corporate bonds were roughly balanced by the gains in the government issues.

I kind of like that. It reinforces my non-quantitative feelings that Total Bond is a decent investment. Collecting a somewhat-miscellaneous grab-bag of investment-grade bonds--with inclusion and exclusions rules decided on by Lehman Brothers--apparently results in plain vanilla behavior.
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Re: How To Think About Corporate Bonds

Post by X528 »

What about tax-exempt municipal bonds?
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Re: How To Think About Corporate Bonds

Post by prioritarian »

000 wrote: Thu Oct 28, 2021 5:51 pm What is the yield spread today? Does it seem big enough to you?
Which yield spread? (The T10Y2Y and T10Y3M look midcycle to me.)

I don't change my bond AA based on yield-spreads that are directly impacted by the business cycle or temporary interventions during a business cycle. I don't know what markets, the economy, or fiscal/monetary authorities will do in 2023 or 2024 so I'm choosing to not react based on a short-term print.
Last edited by prioritarian on Thu Oct 28, 2021 6:49 pm, edited 2 times in total.
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Re: How To Think About Corporate Bonds

Post by 000 »

prioritarian wrote: Thu Oct 28, 2021 6:45 pm
000 wrote: Thu Oct 28, 2021 5:51 pm
What is the yield spread today? Does it seem big enough to you?
Which yield spread? (The T10Y2Y and T10Y3M look midcycle to me.)

I don't change my bond AA based on yield-spreads that are directly impacted by the business cycle or temporary interventions during a business cycle. I don't know what markets, the economy, or fiscal/monetary authorities will do in 2023 or 2024 so I'm choosing to not react based on a short-term print.
I meant corporate yield - treasury yield of same maturity.
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Re: How To Think About Corporate Bonds

Post by prioritarian »

000 wrote: Thu Oct 28, 2021 6:48 pm
prioritarian wrote: Thu Oct 28, 2021 6:45 pm
000 wrote: Thu Oct 28, 2021 5:51 pm
What is the yield spread today? Does it seem big enough to you?
Which yield spread? (The T10Y2Y and T10Y3M look midcycle to me.)

I don't change my bond AA based on yield-spreads that are directly impacted by the business cycle or temporary interventions during a business cycle. I don't know what markets, the economy, or fiscal/monetary authorities will do in 2023 or 2024 so I'm choosing to not react based on a short-term print.
I meant corporate yield - treasury yield of same maturity.

I think that there is a reasonable argument for bond trading based on the yield curve and spreads but I suspect most people who decide to change their bond allocations (e.g. most Bogleheads) don't have that level of sophistication.
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Re: How To Think About Corporate Bonds

Post by 000 »

prioritarian wrote: Thu Oct 28, 2021 7:32 pm I think that there is a reasonable argument for bond trading based on the yield curve and spreads but I suspect most people who decide to change their bond allocations (e.g. most Bogleheads) don't have that level of sophistication.
Oh I agree and wasn't necessarily trying to suggest setting AA based on current spread, just giving OP a way to think about potential future returns other than backtesting.

I look favorably on including corporate bonds in portfolios with large bond allocations, up to say 50% of the bond allocation. It's hard to argue for passive investing, yet exclude one of the largest asset classes just because someone can synthetically replicate corporate bond exposure with some stocks in the past.

As far as in what scenario I might anticipate corporate bonds outperforming a mix of stocks and treasuries, I would say a scenario starting with highly overvalued but fundamentally sound businesses. Think Japan 1989. Were there ever mass bankruptcies of Japanese corporations? No, but the stocks got decimated because they were bid up too high. We might be at a similar point now and see bad stock returns but viable corporate credit.
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Re: How To Think About Corporate Bonds

Post by galeno »

As non-US investors we use one non-hedged TWBM UCITS ETF as our only bond holding.
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Re: How To Think About Corporate Bonds

Post by averagedude »

I like corporate bonds, but to know if you should tilt to them depends on your reasoning of owning bonds to begin with.
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Re: How To Think About Corporate Bonds

Post by prioritarian »

000 wrote: Thu Oct 28, 2021 7:56 pm I look favorably on including corporate bonds in portfolios with large bond allocations, up to say 50% of the bond allocation. It's hard to argue for passive investing, yet exclude one of the largest asset classes just because someone can synthetically replicate corporate bond exposure with some stocks in the past.

As far as in what scenario I might anticipate corporate bonds outperforming a mix of stocks and treasuries, I would say a scenario starting with highly overvalued but fundamentally sound businesses. Think Japan 1989. Were there ever mass bankruptcies of Japanese corporations? No, but the stocks got decimated because they were bid up too high. We might be at a similar point now and see bad stock returns but viable corporate credit.
Good point about corporate bonds being a way to increase risk-return for bond heavy portfolios. (Would still prefer gov bonds during a Japan scenario :greedy)
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Re: How To Think About Corporate Bonds

Post by martincmartin »

averagedude wrote: Thu Oct 28, 2021 9:24 pm I like corporate bonds, but to know if you should tilt to them depends on your reasoning of owning bonds to begin with.
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Re: How To Think About Corporate Bonds

Post by Artsdoctor »

Back in the OLD days, nominal treasuries could be counted on to increase in value during substantial equity bear markets. This opportunity allowed investors to snap up equities while they were "on sale" by liquidating their treasuries which had increased in value. Corporates, while they recovered eventually, did not have the same "flight to quality" as treasuries so if you were counting on corporates to sell during an equity swoon, you would have been disappointed. Nowadays, the yields on treasuries are so low that you can't really count on that pop during an equity market sell-off. Corporates will behave more like equities during a large market downturn so you'll need to decide if that's OK with you; if you don't anticipate having to sell them for your living expenses, you most likely won't suffer.
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Re: How To Think About Corporate Bonds

Post by NiceUnparticularMan »

I agree the first question you have to ask is why are you investing in bonds at all.

If your answer is you are investing in bonds to manage overall portfolio risk, you probably don't need corporate bonds. If your answer is you are trying to match either nominal or real future liabilities/expenses, you also probably don't need corporate bonds. But if your answer is you are trying to build wealth through your bond investments, then maybe you need corporate bonds.

Personally, I am completely uninterested in trying to build wealth through bonds. So, personally, I see no need for corporate bonds.

I note I think some people at least start with deciding their percentage in bonds, and then try to figure out what bonds to hold, and some such people end up being tempted by corporate bonds as part of the mix to help boost expected returns and such.

To me that is backward. I think you should start with the goals for your portfolio, and then use the percentage and mix of bonds which is best suited for those goals. And that could mean something like holding a somewhat smaller percentage of bonds if you only hold Treasuries and such and no corporate bonds, and that could be a perfectly fine alternative to a somewhat larger percentage of bonds where some are corporate, given typical portfolio design goals.

But again some people have a bond percentage fixed at the outset, and that then leads them to getting creative with bonds.

As a final thought, I think some other people take the principle of diversification derived from stock investing and apply it to bonds. In truth, to my knowledge pretty much no one actually tries to buy a market-weighted basket of bonds, and things like "total bond" funds are already being filtered in various ways. Generally, the logic behind stock diversification really does not apply to bonds, and so I think it is a conceptual and practical mistake to see "diversification" as a goal for bond investments, except to the very limited extent that if you do want to invest in corporate bonds, you should diversify WITHIN your corporate bonds. But there is not a good reason to believe you should be trying to diversify among bonds in general, and indeed such a strategy can be counterproductive for many portfolio level purposes.
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Re: How To Think About Corporate Bonds

Post by dbr »

NiceUnparticularMan wrote: Fri Oct 29, 2021 9:20 am I agree the first question you have to ask is why are you investing in bonds at all.

If your answer is you are investing in bonds to manage overall portfolio risk, you probably don't need corporate bonds. If your answer is you are trying to match either nominal or real future liabilities/expenses, you also probably don't need corporate bonds. But if your answer is you are trying to build wealth through your bond investments, then maybe you need corporate bonds.

Personally, I am completely uninterested in trying to build wealth through bonds. So, personally, I see no need for corporate bonds.

I note I think some people at least start with deciding their percentage in bonds, and then try to figure out what bonds to hold, and some such people end up being tempted by corporate bonds as part of the mix to help boost expected returns and such.

To me that is backward. I think you should start with the goals for your portfolio, and then use the percentage and mix of bonds which is best suited for those goals. And that could mean something like holding a somewhat smaller percentage of bonds if you only hold Treasuries and such and no corporate bonds, and that could be a perfectly fine alternative to a somewhat larger percentage of bonds where some are corporate, given typical portfolio design goals.

But again some people have a bond percentage fixed at the outset, and that then leads them to getting creative with bonds.

As a final thought, I think some other people take the principle of diversification derived from stock investing and apply it to bonds. In truth, to my knowledge pretty much no one actually tries to buy a market-weighted basket of bonds, and things like "total bond" funds are already being filtered in various ways. Generally, the logic behind stock diversification really does not apply to bonds, and so I think it is a conceptual and practical mistake to see "diversification" as a goal for bond investments, except to the very limited extent that if you do want to invest in corporate bonds, you should diversify WITHIN your corporate bonds. But there is not a good reason to believe you should be trying to diversify among bonds in general, and indeed such a strategy can be counterproductive for many portfolio level purposes.
I agree with this overall perspective. That is why long ago we just put our fixed income in Treasury and TIPS funds and stopped worrying about it. None of this means it is a mistake to hold total bond or to allocate a significant holding to corporate bond. You just agree that the portfolio risk and return is what you want. As an example I never understood Mr. Bogle objecting to the composition of total bond because it had too much in Treasuries and presumably not enough return.
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Re: How To Think About Corporate Bonds

Post by aristotelian »

I don't really see a role for corporate bonds. Stocks have better return, both absolute and risk adjusted. For safety and non-correlation with the market, Treasuries are historically better and therefore make the ideal pairing for maximizing overall portfolio efficiency. That said, if your only bond offering in your 401k is a total bond fund the includes corporates I wouldn't hesitate to use it.
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Re: How To Think About Corporate Bonds

Post by NiceUnparticularMan »

dbr wrote: Fri Oct 29, 2021 9:27 am
NiceUnparticularMan wrote: Fri Oct 29, 2021 9:20 am I agree the first question you have to ask is why are you investing in bonds at all.

If your answer is you are investing in bonds to manage overall portfolio risk, you probably don't need corporate bonds. If your answer is you are trying to match either nominal or real future liabilities/expenses, you also probably don't need corporate bonds. But if your answer is you are trying to build wealth through your bond investments, then maybe you need corporate bonds.

Personally, I am completely uninterested in trying to build wealth through bonds. So, personally, I see no need for corporate bonds.

I note I think some people at least start with deciding their percentage in bonds, and then try to figure out what bonds to hold, and some such people end up being tempted by corporate bonds as part of the mix to help boost expected returns and such.

To me that is backward. I think you should start with the goals for your portfolio, and then use the percentage and mix of bonds which is best suited for those goals. And that could mean something like holding a somewhat smaller percentage of bonds if you only hold Treasuries and such and no corporate bonds, and that could be a perfectly fine alternative to a somewhat larger percentage of bonds where some are corporate, given typical portfolio design goals.

But again some people have a bond percentage fixed at the outset, and that then leads them to getting creative with bonds.

As a final thought, I think some other people take the principle of diversification derived from stock investing and apply it to bonds. In truth, to my knowledge pretty much no one actually tries to buy a market-weighted basket of bonds, and things like "total bond" funds are already being filtered in various ways. Generally, the logic behind stock diversification really does not apply to bonds, and so I think it is a conceptual and practical mistake to see "diversification" as a goal for bond investments, except to the very limited extent that if you do want to invest in corporate bonds, you should diversify WITHIN your corporate bonds. But there is not a good reason to believe you should be trying to diversify among bonds in general, and indeed such a strategy can be counterproductive for many portfolio level purposes.
I agree with this overall perspective. That is why long ago we just put our fixed income in Treasury and TIPS funds and stopped worrying about it. None of this means it is a mistake to hold total bond or to allocate a significant holding to corporate bond. You just agree that the portfolio risk and return is what you want. As an example I never understood Mr. Bogle objecting to the composition of total bond because it had too much in Treasuries and presumably not enough return.
Yeah, despite my conceptual quibbles, as a practical matter if you want to use a low-cost total bond fund, or a single fund approach where one of the underlying investments is a total bond fund, that is not an issue to me. Heck, I'm probably going to end up transitioning to such an approach myself.

My point was more directed to people who are interested in taking control of their allocations at a more granular level, and for many of them I think they can reasonably decide they just don't need corporate bonds. But it is not like I think some such investments are going to be very harmful either.
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Re: How To Think About Corporate Bonds

Post by prioritarian »

martincmartin wrote: Fri Oct 29, 2021 7:16 am
averagedude wrote: Thu Oct 28, 2021 9:24 pm I like corporate bonds, but to know if you should tilt to them depends on your reasoning of owning bonds to begin with.
For someone starting retirement, to avoid running out of money in retirement. Don't want to have to play the Squid game.
A modest equity position would likely do a better job of reducing risk of running out of money than a larger corporate bond position (less correlation with total bonds or government bonds). I do understand that some retired investors may be equity averse so in that case corporates could have a "psychological" role in portfolio construction.
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Re: How To Think About Corporate Bonds

Post by etfan »

Is there no meaningful distinction in terms of risk between corporate equities and corporate bonds? Why do some investors say they want to keep their risk on the equities side and disregard the corporate bonds class entirely?

Does it not make sense for an investor to not want the government bonds to be ALL of their safe assets? Government bonds are considered "risk-free" historically, but what if an unlikely event changes that in the future?

This is similar to the international vs. US debate. Yes, so far US stocks proved sufficient but the counter-argument is that something might change that disrupts that dominance. Why not apply the same logic to bonds?
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Re: How To Think About Corporate Bonds

Post by Karamatsu »

As far as in what scenario I might anticipate corporate bonds outperforming a mix of stocks and treasuries, I would say a scenario starting with highly overvalued but fundamentally sound businesses. Think Japan 1989. Were there ever mass bankruptcies of Japanese corporations? No, but the stocks got decimated because they were bid up too high. We might be at a similar point now and see bad stock returns but viable corporate credit.
Although the scenario you're imagining seems possible, it's important in any discussion of corporate bonds to point out that many Japanese companies did default on their debt and so were technically bankrupt. The reason you didn't see vast numbers of firms closing their doors was that banks held the majority of the debt, and if the banks recognized all those corporate defaults, they would have had to mark down their assets, after which the banks themselves would fail. To avoid a crisis, the government suspended mark-to-market and, in effect, banks simply looked the other way, carrying the bad debt on their balance sheets at par, as if nothing had ever happened. This allowed zombie companies to continue operating, continue employing people, continue paying salaries, and avoided the catastrophe of cascading bankruptcies and massive unemployment. But crucial to this discussion, the bonds became pretty much worthless except as the playthings of speculators. Would they ever be worth anything? You needed nerves of steel and, as it turned out, a tremendous amount of patience and the financial resources to hold worthless paper for decades.

Overall the decision was probably a good one, but it took twenty years to unwind, so... very different from the US, where people and government have no patience for long-term solutions, so prefer to get pain over with quickly as long as it can be shifted to ordinary people and leave those at the top unscathed. So for example in 2008-2009 we bailed out banks, the executives got bonuses, and ordinary people lost their homes. That's how America prioritizes things. Japan is different, and here things pretty much stayed as they were, frozen, or almost so. To the extent that the financial situation did slide into a coma, with a few exceptions (there were runs on some banks, etc), the crisis here was more like watching metal rust. Stability was purchased at the cost of stagnation.

Take your pick, I guess, but the takeaway is that there's a very fine line you have to walk if equities are going to plunge while companies remain able to service their debt. I think in the US there is probably too much mutual cross-dependency between the equity market and the real economy for that to work. In Japan the two are still quite separable and the stock market plays very little role in the overall economy (arguably it plays very little role in investment), so the scenario you're describing would be easier to pull off.

Anyway, according to the 2020 Annual Global Corporate Default and Transition Study published by S&P Capital IQ, the global corporate debt default rates in 2020 were:

Code: Select all

AAA          0.00%
AA           0.00%
A            0.00%
BBB          0.00%
BB           0.93%
B            3.52%
CCC/C        47.48%
Historically, the worst one-year default rates (since 1981) were:

Code: Select all

AAA          0.00%
AA           0.38%
A            0.39%
BBB          1.02%
BB           4.24%
B            13.84%
CCC/C        49.48%
These maxima were for different years but as you might expect, clustered around the 2008-2009 and 1999-2001. The relative risk levels of investment-grade versus junk are pretty clear.
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Re: How To Think About Corporate Bonds

Post by 000 »

Interesting. Thank you for sharing and expanding my knowledge.
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Re: How To Think About Corporate Bonds

Post by seajay »

(2019) $30T stock cap, $9T corporate bond cap - bonds that firms have sold to raise cash.

Broadly the theory is that corporate bonds yield a premium above treasury bonds comparable to their default risk, and that being long or short bonds yields the same. The UK for instance don't even bother taxing capital gains in their treasury bond (Gilt) prices as broadly it all just washes.

In buying stocks you are also buying into their debts, short corporate bond positions. Many do like to also buy bonds for the better risk adjusted reward it provides (same reward with less volatility = higher Sharpe ratio), invest $30 into stocks, $9 into bonds (77/23) in effect buys both the firms shares and covers its borrowings/debt (corporate bonds), which leaves a purer stock only position rather than otherwise being stock + short bonds. De-leverages otherwise leveraged stock (leverage just broadly scales volatility, not rewards).
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